Financial markets

Investing

Rotation schmotation

ONE of the supposed themes of the year was the coming great rotation out of bonds and into equities (see my January post on this, which suggested at best there would be a mini-rotation). In fact there has been no switching out of bonds at all in the US mutual fund figures from Morningstar; in the first quarter, bond funds received $78 billion of inflows, almost exactly the same amount as flowed into the three categories of equity funds. In March, taxable bond funds were the single most popular category. Cash is definitely still flowing out of money market funds (unsurprisingly, given the yields) to the tune of $54 billion in March alone.

If you want further confirmation that bonds are not unloved, you can look at T-bonds (the yield on the 10-year has fallen a third of a point since March 11) or junk bonds, where spreads are around half a point lower than they were at the start of the year, according to S&P. This week's column focuses, through the prism of gold, about how hard it is to square the various market movements; it is possible to square falling commodity prices with lower government bond yields, but not with the Dow and S&P making all-time highs. Nor is it easy to make the case that gold is in retreat because the Fed is losing the appetite for QE; recent US data have generally been weak and, in any case, the Bank of Japan has supposedly gone QE-mad.

David Woo, the currency strategist at Bank of America Merrill Lynch describes the dilemma in a different way

The commodity market is saying global growth is slowing. The US equity market is saying US consumers are still going strong. The FX and European sovereign markets seem to believe Mrs. Watanabe is about to embark on a global shopping spree. We think it is unlikely that these markets will all turn out to be right. Something will have to give and a major re-alignment of the markets, the odds of which are rising, will probably not be either smooth or benign, in our view.

Mr Woo thinks that the evidence, such as Chinese Q1 GDP and the various EU numbers, suggest the global economy is slowing. It looks like we may be going through the familiar pattern of recent years, in which first quarter optimism peters out in the late spring. So what explains the strength of US equities? Mr Woo thinks the hope is that rising US house prices will offset the effect on consumers of austerity (don't forget the payroll tax increase), but the recent falls in consumer confidence are not encouraging; he also doubts the scope for massive Japanese buying of foreign assets, given that many institutions are already overweight.

In a slowing economy, bonds still look like a good short-term bet despite the likelihood that they will offer very poor long-term returns. A lot of people have made bearish bets on Japanese bonds in the last 20 years; they still haven't came good. Inflation expectations have come down in recent months and that, given the weakness of commodity prices, is hardly surprising (eventually, this will be good news for consumers, but only if they keep their jobs). But sluggish growth will of course mean that the debt burden will not come down, which means further crises loom.

And that brings me to the Reinhart/Rogoff brouhaha. I think I've been consistent in arguing that it's total debt, rather than just government debt that's the problem; this paper from the BIS looks at threshold numbers for household debt and corporate debt, for example. Ireland and Spain looked OK on government debt-to-GDP before the crisis but then they didn't. But it was hard not to think of the old graffito - "Archduke Franz Ferdinand found alive; First World War a mistake". Instead we could have "Debt spreadsheet wrong; four years of austerity a mistake." This reprinted graph from BCA Research shows the problem.

It seems clear there are no hard-and-fast rules. There is obviously a huge difference between America, which has the exorbitant privilege of borrowing in the global reserve currency, and Greece when it comes to scope for fiscal stimulus. Still, it is hard to believe that any country, even the US, can run deficits of 10% or so of GDP for very long without running into problems. But when everyone is cutting back, one gets a fallacy of composition at the global level; you can't reorient your economy to exports when your neighbour is trying to do the same. It would be nice to pretend that your blogger has the answer in the form of a 26-point plan to solve the world's problems but he doesn't; it's his job to ask questions.

Readers' comments

To much of the pie has gone to the top, where the propensity to save is high. Add to that the lack of confidence among businesses and consumers, and there is more money around than there are real investments to absorb it.
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So it ends up in the casino.

Not to worry, Buttonwood. You may not have a simple answer to the problem. But you can bet that the commenters will have one. Actually, several (probably mutually contradictory) ones. They won't work, of course, but they will be answers. ;-)

The globe has a record 25% savings rate. However, the third world is saving 50% and the west is saving nada. To "stimulate the economy", bankers are borrowing third world capital, and misallocating it into Keynesian pyramids. This strategy is producing endless banker demands for taxpayer bailouts.

We need a new strategy. A gold standard would allow the free market to allocate capital efficiently. We need factories to employ people, not empty McMansions.

If QE in the US doesn't deliver the growth and unemployment it dreams of, the Fed has two choices:
1) Keep financing and the US turns into Japan (who we should watch closely to see how fun that ride is), or
2) Cut spending with structural reform and get a recession, deflation, BUT eventual recovery

"You may not have a simple answer to the problem. But you can bet that the commenters will have one."
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Personally, I've doubled down on aloe verde farms, jojoba farms, and llama and ostrich ranches. What could go wrong? :)

And your algorighms probably need to work out a way to differentiate retail investors doing their own research, vs those who have someone (who they presume to be an expert) making their decisions for them. Whether formally, as their investment advisor, or informally, as just a talking head with a TV show....

Pretty good - if you'd have just left out that one long sentence about gold.

With CBs buying bonds straight from governments at like 0% yield, that sets the mark for rates. The flood of new QE money has to go somewhere. Most of it goes to demand deps, but enough leaks into bonds and stocks to support them; stocks are/were a nice momentum play (until very recently) - fun while it lasted.

Answers? - Why not cover the field and see what happens? Japan is going to one extreme, and the Germans seem determined to have the ECB at the other; the US is somewhere in between. Let's just wait and see who's 'least wrong'.

Nor is it easy to make the case that gold is in retreat because the Fed is losing the appetite for QE...

(Maxwell Smart voice)

"Would you believe, the punters sold gold in order to buy Bitcoins?"

"Ah! I didn't think so."

"Would you believe, punters sold gold in order to have liquidity after losing on Bitcoin?"
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Do we know what pct of the market participation is by retail investors? (Gotta work that into my algorithms.)